I’ve seen many links to this Paul Caron blog post arguing that Dwight Howard didn’t really take a pay cut by moving to Houston once you take taxes into consideration, but I’m not sure the math adds up. The Lakers offered him $118 million over five years (the maximum they were allowed to offer) while Houston offered just $87.6 million over four years. On the flipside, though, California has a top marginal income tax rate of 13.3 percent to Texas’ zero income taxes.
On the face of it, the pay cut from going to Houston is bigger than 13.3 percent. On the other hand, it’s not a strict apples-to-oranges comparison. The main reason the total value of the Lakers’ contract is so much larger is that it includes an extra year. On a per year basis, the pay cut from going to Houston is relatively modest.
But then on the other hand, 13.3 percent is a big overstatement of Howard’s effective tax rate. For starters, it’s a marginal rate on taxable income so much of Howard’s money won’t be subject to that taxes. Another important consideration is that state and local taxes are deductible for federal tax purposes. Which is to say that for every extra $10 in state income taxes Howard would pay by living in California, his federal income tax bill is reduced by $3.96.
So if we oversimplify a bit a bit and say the Lakers offered to pay $23.6 million per year and Houston offered to pay $21.9 million a year the question is does Howard receive $1.7 million in annual tax benefits from living in Texas? Well, 13.3 percent of $23.6 million is $3.14 million in extra state income taxes. On the other hand, that’d earn you a $1.24 million federal income tax deduction. So that looks like Howard’s after-tax income in California might be $200,000 lower than in Texas. But of course that’s assuming that Howard’s full nominal income would be taxed at the top California marginal rate, which seems unlikely. When you consider that professional athletes are also hit with jock taxes for playing in road games, it looks like a wash to me on a year-to-year basis. Then you have to consider the value of that fifth year. The most likely scenario, of course, is that at the end of his four-year deal with Houston, Howard will be able to sign another lucrative contract. But that’s not necessarily the case. It’s totally possible that Howard will have a career-ending injury over the next four years, or that poor play will lead his perceived market value to plummet. Alternatively, if he plays very well the problem with the Houston deal will be that under the NBA’s collective bargaining agreement the amount of money a player is eligible to be paid in year N+1 is a function of his salary in year N. If we assume that four or five years from now Howard would be able to command an additional max contract, then the foregone raises in Houston could be even more costly.
Long story short, I doubt that Howard has done his finances a favor by moving to Texas. But that is due to some idiosyncratic features of the way the NBA collective bargaining agreement handles superstar players. A lesser performer fielding two mid-level contract offers could substantially increase his after tax income by signing with the Rockets, Mavericks, Spurs, Heat, or Magic rather than the Lakers, Clippers, Warriors, Knicks, or Nets. More broadly, in general the tax code is very unfavorable to professional athletes who tend to have very high annual earnings but short careers, and so players would be well-advised to take this kind of issue into account.